Chapter 10 CBA and valuation1 CHAPTER 10 Cost-Benefit Analysis and Valuation

Chapter 10 CBA and valuation 1

CHAPTER 10

Cost-Benefit Analysis and Valuation


Cost-benefit analysis

• Typical questions– Investment in a nature preserve area?

• Costs can be determined (but how)?• Benefits: difficult => valuation methods

– New road network?• Benefits might be estimated• But what about the costs (in particular for nature

and landscape)? => valuation methods


Cost-benefit analysis (general expression)

) i + (1

) i + (1 = t

=t

0=tt

=t

0=t

tT

ttT NCB

NPV

NPV = net present value (see also chapter 4)B = benefitC = costsN = net result (can be negative!)i = discount rate (assumed to be constant during the total period)T = total period of the projectt = time (in years).


Cost-benefit analysis; alternative route to quantify

• General expression (national perspective)

• Reminders:– Aggregation over time!– Framework not always suitable

EEGRPSCSWCB W= WelfareCS= Consumer surplusPS= Producer surplusGR= Government revenueEE= External effects


Cost-benefit analysis (principles)

• Opportunity costs

• Discount rate

• Theoretical basis– Pareto criterium– Hicks Kaldor criterium

• Level of analysis (regional, national, etc.)


Cost-benefit analysis (classifications)• Primary /Secondary benefits and costs (goal);

Example: – Road (primary goal)– Attracts an industry (secondary goal)

(Both secondary benefits and costs!) • Direct and indirect benefits and costs (main actor /

other actors); Example:– Government is main actor (direct)– Other actors (e.g. Producers & consumers):

indirect


Cost-benefit analysis

• Harberger rule: Only include effects on ‘other’ markets if they are:– Related and– Distorted

• This Harberger rules contributes substantially to ease Cost-benefit analysis in market economies!

An example of CBA for a project with considerable external effects

• Look at the complete set-up and also the wording

• Only main categories have been provided (based on an actual example)

• Difference between a national and a regional approach (e.g. rural area)



National CBA Scheme; natureCosts Benefits

Net product of factors in previous use

A Net product generated by nature

E

Cost of additional factors

B Net product of released factors

F

Maintenance C Non-marketable benefits from nature

G

Non-marketable benefits; previous use

D Allocation losses H

Total S Total S


Rural CBA Scheme; natureCosts Benefits

Net product of factors in previous use

A Net product generated by nature

E

Cost of additional factors

B Net product of released factors

Fr

Maintenance C Non-marketable benefits from nature

Gr

Non-marketable benefits; previous use

Dr Allocation losses Hr

Total Sr Total Sr


Valuation in relation to ‘nature’

• Elements of total economic value (TEV)– Measurable by price mechanism: secondary

benefits (Direct / Indirect)– Not measurable by market price mechanism

• Use values– Current: primary benefits– Future use value: option value

• Non-use value– Existence value (several items)– Bequest value (future generations)– Vicarious use (non-users => users)


Valuation in relation to ‘nature’ (fig)Total value

Value measurable by the price mechanism:Secondary benefits

Value not measurable by the price mechanism

Direct secondary benefits

Indirect secondary benefits

Use value Non-use value

Current use value:Primary benefits

Future use value:Option value

- existence value- bequest value- vicarious-use value


Traditional valuation methods

• Market approach (see chapter 5)– Exchange value at the market

• Income approach– Expected value of future net benefits

• Cost approach– Compensation for the costs of producing the

goods


Non-market valuation; principles

• Central issue is: what are individuals willing to pay (for more public goods) or willing to accept (less public goods)

• Compensating and Equivalent welfare measures

• now Compensating Surplus (CS) and Equivalent Surplus (ES): changes in quantities!


Valuing changes in public goods?

Inverse Hicksian demand curves for public goods

x

px

px(x|pq0,q0,u0)

px(x|pq0,q0,u1)A

B

x0x1

CSWTP

CSWTA

ESWTP

ESWTA

From x0 to x1

Without change: u0

With change: u1


Stated Preference techniques

• Contingent valuation (WTP/WTA)– Hypothetical market– Obtaining bids– Estimating WTP/WTA

• Choice modelling– Evaluating attributes (different combinations)


Observations on WTP / WTA

• Reference point is important

• One observes systematic differences: WTA>> WTP

• Cannot be explained by standard neoclassical economic theory =>prospect theory; takes the reference point into account


Revealed preference techniques

• Starts from actual observations on behaviour in the market

• Travel cost method– Calculated from number of visits and travel costs– Travelling is a disutility– Does not consider substitution possibilities– Only the use value is estimated– How to valuate time?


Revealed preference techniques• Hedonic pricing

– Based on price differences due to specific characteristics (e.g. the environment)

– Often based on differences in house prices (transactions of a property which has both individual characteristics and an implicit valuation of the ‘environment’)

– Data and level of detail can be a problem

• Example),...,,( 21 nzzzfP

P = ‘transaction’ price ; z’s are attributes


In practice

• Method depends a lot on:– Type of question– Available data

• There will always be discussion about non-market valuation methods


• Central issue is: what are individuals willing to pay (for more public goods) or willing to accept (less public goods)

• Compensating and Equivalent welfare measures (importance of reference point)

21Chapter 10 CBA and valuation


Change in Welfare Welfare criterion WTP or WTA Improvement CSWTP WTP to enable improvement Improvement ESWTA WTA if improvement does not take

place Deterioration ESWTP WTP to avoid deterioration Deterioration CSWTA WTA if deterioration occurs


Observations on WTP / WTA

• Reference point is important

• One observes systematic differences: WTA>> WTP

• Cannot be explained by standard neoclassical economic theory =>prospect theory; takes the reference point into account


Conclusions

• Cost-Benefit Analysis is powerful method to determine consequences of different alternatives (if one believes the basic assumptions of welfare economics)

• The provision of public goods and the valuation of external effects might is not an easy task

• Several methods are mentioned


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Chapter 10 CBA and valuation1 CHAPTER 10 Cost-Benefit Analysis and Valuation